Non-Traditional Income Options
- 50 mins 18 secs
Experts explain how non-traditional income can help clients meet their income needs in the 2020’s. They evaluate senior secured notes and legacy non-agency RMBS as two options for financial advisors to diversify fixed income exposure.Channel: Catalyst Funds
Larry Milder: Hi, this is Larry Milder, National Sales Manager for Catalyst Funds. Welcome to today's continuing education presentation, Understanding How Non-Tradition Income Options Can Help Your Clients Meet Their Income Needs in the 2020s. Catalyst Funds is pleased to bring you this presentation today. At Catalyst, we strike to provide innovative strategies to support financial advisors and their clients in meeting the investment challenges of an ever-changing global market environment. The foundation of our investment philosophy is built upon three key strategies, Alternative/Hedged Strategies, Income-Oriented Strategies, and Equity-Oriented Strategies.
Larry Milder: Today's speakers are Stan Sokolowski and Natalia Lojevsky from CIFC Investment Management, and Leland Abrams from Wynkoop Financial. Stan is Managing Director, Senior Portfolio Manager, and Deputy CIO at CIFC Investment Management. He's Senior Portfolio Manager of Floating Rate Income Strategy at Catalyst Funds, the Catalyst/CIFC Floating Rate Income Fund. Natalia Lojevsky is Executive Director at CIFC. Leland Abrams is Chief Investment Officer at Wynkoop Financial and Lead Portfolio Manager of the Catalyst Enhanced Income Strategy at Catalyst Funds.
Larry Milder: We're pleased to bring you experienced income-oriented managers today to discuss an evaluation of senior secured notes and legacy non-agency RMBS as two compelling options for financial advisors to diversify fixed-income exposure. First will be hearing from Stan and Natalia with an introduction to senior secured corporate loans, followed by remarks from Leland Abrams, who will discuss non-agency RMBS and the opportunity this asset class presents for investors seeking non-traditional income options. Mr. Abrams will also cover mortgage-backed securities. Now, let's turn things over to Stan and Natalia.
Natalia Lojevski: Thank you, Larry. Good afternoon, everyone. This is Natalia Lojevsky from CIFC Asset Management. Just a quick few words about CIFC before we dive into the world of senior secured corporate loans. CIFC was founded in 2005 and is a global credit specialist. Today, the firm manages over 26 billion in assets across corporate structured and opportunistic credit and serves over 300 institutional investors globally that include the largest pools of capital such as sovereign wealth funds, insurance plans, insurance companies, wealth management platforms, family offices, and through our partnership with Catalyst Funds, retail investors.
Natalia Lojevski: Stan and I would like to use this opportunity to not only educate but to provide some data and analysis in order to demystify the large liquid and mature market of senior secured corporate loans. There's a lot of misinformation out there and countless doom and gloom headlines meant to grab attention and stoke fear. Our hope today is to provide some perspective and real data in order to help you and your clients with this investment opportunity.
Natalia Lojevski: The good news is if you're familiar with traditional fixed-income assets such as high-yield bonds, investment grade bonds, emerging market bonds, treasuries, munis, you already know the loan asset class. It has the same issuers, it is invested in by, underwritten by, and rated by all of the same players involved in those traditional fixed-income markets. There are a couple of key differences, namely loans are floating rate and secured by collateral. Loans also possess several other open quality benefits and we will take you through all of this in detail now.
Stan Sokolowski: Thank you, Natalia. I will kick it off here with a little introduction. I'll be probably repeating some of the themes that Natalia highlighted, but I do think it is important to fully understand the asset class. It is a trillion-dollar-plus market. It's large, it's liquid. When you hear the word "loans", you'll also hear bank loans, loans referred to as floating rate loans, institutional loans, leverage loans, secured loans, et cetera. It's all the same market. Secured loans are senior in an insurer's capital structure. We'll be talking a little bit more about that today. As Natalia mentioned, they're floating rate so there's minimal sensitivity to changes in interest rate, and that's probably a good thing where rates are and given where rate volatility is these days.
Stan Sokolowski: Historically, this is an asset class that has performed in a variety of economic environments, from prosperity to recession, inflation to deflation. One health warning, if you look at the history of the asset class going back through three decades, your down periods, which are two, the year 2020 and the year 2008, those are associated with crisis, so that's your health warning.
Stan Sokolowski: A minute on the evolution of the market from where it was 30 years ago and where it is today, 30 years ago, it was a bank-only market. This is how banks made their bread and butter. They borrowed money from their depositors, and they lent it to corporations on a term basis. That's the spread that banks made. It avoided interest rates risk but obviously exposed banks to liquidity risk. Over time, the regulators have been busy regulating banks out of the lending business. They don't obviously want to use FDIC-insured deposits for risky lending activities. However, as that process has evolved, non-bank lenders, and Natalia highlighted a number of them from sovereign wealth funds, pension funds, family offices, endowments, insurance companies, and even retail investors, have begun to get involved in the loan asset class. We'll discuss the attributes that have attracted them.
Stan Sokolowski: Today, the banks are large originators of the loans, just like banks are large originators of bonds and the pools of capital today have migrated from FDIC-insured deposits to other pools of capital. Most senior secured loans as we know them today are issued by below investment grade borrowers. They include a variety of companies, from Dell Computers, Delta Airlines, to a number of financially sponsored issuers. They generally are larger companies. These are not middle market and direct loans. As I mentioned, many names are familiar. We discussed floating rate. We discussed the various ways loans are referred to. I think it's important to do a little accounting here. If you think back to an accounting 101, the formula assets = liabilities + equity, you can think about how an issuer's balance sheet is built.
Stan Sokolowski: On the asset side of the balance sheet, an issuer has their assets, including cash, accounts receivable, property plan and equipment and other assets of the entity. On the other side of the balance sheet, they have their owner's equity, which sits at the bottom of the capital structure and their other liabilities from unsecured obligations, all the way up to senior secured obligations like loans, which sit on the top of the cap structure. What does that mean? Well, in the business of lending money, whether it be loans or bonds, your risk is potential of loss. Senior secured investors are the first in line to benefit from any security and collateral to the extent there is a default and a loss, and we'll spend some more time on that today.
Stan Sokolowski: On the next page, we show a visualization of the capital structure of a company, so you can see at the very top is your senior secured debt. Then, usually bonds are below the senior secured debt, and then you'll have other instruments like preferred shares and, ultimately, all the way at the bottom, you'll have your common equity holders. Essentially, as you think about ranking, the top of the capital structure is up in quality, the bottom of the capital structure is down in quality. If we think about the risk/reward equation again, equities take the most risk, obviously have the most reward associated with them. Loans take a much lower risk profile and therefore are earning a coupon, which is comprised of a spread and a base rate.
Stan Sokolowski: Our next page, we will compare the differences between loans and bonds, and as Natalia highlighted in her introduction, the good news is if you're familiar with traditional fixed-income markets, you're probably already familiar with the loan market. Some of the key commercial and legal differences are bonds are obviously securities, loans are not securities. Bonds are generally fixed rate; loans are generally floating rate. Bonds are generally unsecured, loans are secured, and then with respect to familiarity, everybody knows what a bond is, however, there seems to be unfamiliarity bias associated with the loan asset class. If you generally have a question about the loan market, answer it by using the knowledge you have about traditional fixed-income and bond markets and 95% of the time you're going to have the answer.
Stan Sokolowski: The legal difference, which I highlighted up front was that loans are not securities. What does that typically mean? Well, loans do not settle in electronic clearing systems like bonds, so the settlement process after you trade them is a bit different and a longer process than T + 2. Why do issuers use loans to finance their business operations? One of the reasons can be cost. Obviously, if you give security as an issuer, that is a lower risk instrument and therefore your cost of financing is lower. Loans are prepay able, just like the mortgage on your house. That provides a CFO or a CEO with flexibility to manage their balance sheet. There's also business and capital structure objectives. If a CEO and CFO expect changes to their business, acquisitions, divestitures, cashflow changes, they may want the flexibility to pay down the senior secured component of their balance sheet.
Stan Sokolowski: They may consider other alternatives like high-yield bonds or other bonds, which are longer dated and come with prepayment penalties. There's a lot of quid pro quo and balancing that corporate leaders do when deciding how to finance their balance sheet.
Natalia Lojevski: Yeah, so here's a good representation of that familiarity that we keep mentioning. Here, you can see how the loan market stacks up to the traditional fixed-income markets. Today, at 1.2 trillion, it is comparable in size to its sister asset class, the high-yield bond market and gaining on those very well-known investment grade bond markets. Sticking with the familiarity theme, it often helps to be reminded of who actually issues senior secured corporate loans and where your money is going when investing in this asset class.
Natalia Lojevski: When we're on the road visiting clients in different parts of the country, Stan and I often play a car game of spot the loan issuer. Usually in just a few miles of road, very familiar loan issuers come up such as Burger King, Dick's Sporting Goods, Dollar Tree, Petco, Pizza Hut, Camping World, Goodyear Tires, and many, many others. This is all to say that these are large, very well-known companies with multi-million dollars in annual sales that use proceeds for growth, capital improvements, research and development, and create millions of jobs in the real economy.
Stan Sokolowski: Okay, so let's talk about those investors we mentioned earlier. Today, they're composed of a variety of different types of institutions who have different investment objectives, including liquidity needs, target returns, and risk objectives. They include, as we mentioned, retail as well as institutional investors as well as collateralized loan obligations, and I'll define quickly a CLO. It's essentially a bank, so as the banks have been regulated out of the lending business, new entities have had to form to provide the capital for employment and growth in the economy. That's what CLOs are today.
Stan Sokolowski: I mentioned there's been a big evolution. You can see how the loan market has grown. You can also see how the investors have also evolved over time. Why do these investors invest? They like the various attributes of the asset class, the secured nature of it, the seniority, the floating rate, the income and the lower volatility profile. We'll be highlighting each of these as we move through the presentation.
Stan Sokolowski: Investing in credit loans is on the surface or commercially no different from investing in most of any other asset class with which you're familiar. We obviously consider the macro environment. We consider the market. We look at things like liquidity and relative value, not dissimilar to other bond or equity markets. We do industry analyses. We consider companies specifics and then, obviously, the transaction itself, the use of proceeds and the capitalization of the business.
Stan Sokolowski: In the loan and credit world, we essentially look at something called the Five Cs, and that incorporates those top highlights that I just mentioned, but the character of the issuer, the capitalization, the collateral, the conditions of the market, and the capacity of that issuer to pay us back our money.
Natalia Lojevski: Yeah, so at this point, we've gone through a pretty detailed overview of the loan asset class, so probably make sense to summarize the key up in quality benefits of loans. Those include a long and proven track record of positive performance. Loans perform in a variety of market and economic conditions, including low growth and even slightly recessionary environments. Loans are secured and senior obligations, as we've mentioned, which historically leads lower loss outcomes in the event of a default.
Natalia Lojevski: Given their seniority and security features, loans have historically had significantly higher recovery rates than unsecured debt such as high-yield bonds. Loans also have a better risk-adjusted return profile as measured by current levels of excess spread. They have a lower correlation profile to other asset classes and importantly loans demonstrate a lower volatility profile compared to many other asset classes, and we'll go through some of that in more detail in the upcoming slides.
Stan Sokolowski: I mentioned earlier the annual return profile of the asset class. Here's a pictorial. This is the Credit Suisse leveraged loan index going back to 1992. You can see the overall consistency of the performance. It's a mid-to-upper single-digit performer consistently. I did mention the health warnings, crisis periods. That's generally where all asset classes struggle. That is mostly due to panic and liquidity selling. That does not discriminate even for loans. In fact, even some of the fear asset classes like gold were down dramatically during March of 2020.
Stan Sokolowski: The final highlight I'd make on this page, this is through April, I believe, and you can see it's representing that year-to-date loans are down 9%. We're essentially at the end of June now and loans are down less than 4%.
Natalia Lojevski: Aside from the consistency that Stan just mentioned, the key part of a portfolio construction is certainly the correlation profile of an asset class. Can it provide balance to other parts of the portfolio and bring down the overall volatility? Here, we show some analysis that clearly demonstrate this attribute for the loan asset class and its lower correlation to many other asset classes often seen in client portfolios.
Stan Sokolowski: On the next page, we'll talk a little bit more about performance. Two pictorials here. Number one, if we look at cumulative returns for a variety of asset classes, essentially since the depths of the last crisis until March of 2020, we can see on the top part of this page how asset classes have performed. It's pretty obvious that equities are the asset class to buy and hold, and hopefully you can ride through the volatility without being shaken out. Unfortunately, many investors cannot ride through that volatility and are essentially seeking lower volatility in income-producing alternatives.
Stan Sokolowski: If we look at this chart and we take those same asset classes and we adjust them for volatility for that same period of time, we can see that U.S. loans have actually been the number one performer on a risk-adjusted basis. I think that's important because the investors with whom we work today are seeking two things, income and a lower volatility.
Stan Sokolowski: On the next page, we'll talk about the conundrum of income, and the top pictorial chart on this page represents the amount of negative-yielding corporate debt outstanding. Now, total debt of this number is much more enormous, but it's essentially hard for investors to find income in the world in which we exist today. There's a lot of secular pressures from inflation to growth and, obviously, interest rates, but seeking income is a huge challenge.
Stan Sokolowski: There's been a Japanization of developed market bond markets and that has, as I said, been a huge challenge for anybody seeking income. Loans have been one solution for investors who seek to achieve higher income on a lower volatility basis.
Natalia Lojevski: Some other observations for the loan market, let's start with the defaults. The default on loss expectations have certainly increased in recent months as we navigate through a difficult economic reopening post the pandemic lockdown. If you simply listen to the news headlines out there, you would think that every company is defaulting, and Armageddon is upon us. We often remind clients of Mark Twain's wise words here. "If you don't read the newspapers, you are uninformed. If you read the newspapers, you are misinformed." In fact, as you can see in the top chart, corporate defaults in the loan market are barely above historic lows currently. Again, have default prospects increased? Yes, certainly they have. However, they will most likely be concentrated in sectors and issues with direct virus and shutdown exposure, including smaller, lower quality and overindebted issuers.
Natalia Lojevski: Another observation is asset class yields. Loans provide one of the highest yields across fixed income today, and as Stan just mentioned and took you through the fixed-income conundrum, this is an important consideration for yield-starved and income-oriented investors who are barely getting paid to take on the duration risk and rate volatility associated with those traditional fixed-income markets.
Natalia Lojevski: In fact, with global yields at such low levels, unlikely to stay there for some time. Traditional investment grade and sovereign bonds are practically becoming cash surrogates but with greater volatility. Investors are also being driven down the risk spectrum, but are also probably not being adequately compensated there, as you can see by the current yields on unsecured high-yield bonds, which sit below loans in the capital structure, but paying not even an extra 100 basis points despite their less secure position.
Natalia Lojevski: Finally, a bit of a fake news chart here. Many retail investors incorrectly assume that floating rate loans only perform in rising interest rate environments. This is a result of many years of lazy marketing and, again, those misleading or misinformed headlines. As you can see in the analysis in the bottom right-hand chart, floating rate loans are not a rate product and can perform well in rising, flat, and also falling rate environments. Last year, 2019, is actually a good case study here. As a reminder, the Federal Reserve carried out three interest rate cuts and loans still had one of their best years in terms of performance and being a year up over 80%.
Stan Sokolowski: Okay. Let's talk about portfolio allocation. What do your clients need? What risks are they seeking to embrace? What risks are they seeking to avoid? This is J.P. Morgan's long-term capital markets assumption page. They update this annually. It's available on their website and it's probably something that all clients should be considering. Essentially, it looks at expected returns for the next 10 to 15 years for a number of asset classes, and then they also adjust for a risk return profile. You can see how loans have a much lower annualized volatility and a pretty decent expected return profile.
Stan Sokolowski: I'm going to move on to the risk-reward analysis on the next page. Many clients today are very concerned about risk and loss of principle and, "Oh, I'm going to lose money here. I'm going to lose money there." That's correct. Investors get paid to take risks and risk is the possibility that you impair a portion or all of your capital when making an investment. Investors get paid to take risks in the equity market. Investors get paid to take risks in the bond market and, yes, investors get paid to take risks in the loan market.
Stan Sokolowski: How do we define risk in the loan market? Well, it's essentially the product of defaults multiplied by losses, so in the credit world, defaults are not necessarily bad, but losses are. If we think about the history of the loan market going back to the early 1990s, the average default rate is about 3%. Now, it's gone materially higher and it's also been materially lower. The average recovery rate is just short of 70%, which means you've essentially lost about 35% of your money when you have experienced a default. These credit costs are experienced by all financial institutions, even Jamie Dimon at J.P. Morgan is exposed to these probably costs.
Stan Sokolowski: The real question for investors is, "Am I getting paid for the risk I'm taking?" This table is a way to represent those risks or essentially what is priced into the thing. In the footnotes, we look at the J.P. Morgan leverage loan index. We look at the dollar price and the yield for which it can be purchased today. Then, on the table, we look at recovery rates, which are the inverse of loss rates. On the vertical column on the left, we look at where defaults could get to. Now, during the Great Financial Crisis, defaults spiked into that double-digit range and losses ticked up, but you can see that if you purchased this asset class today at that dollar price, at those yields, it's very challenging to lose money. You would need these default rates and pretty severe loss rates to occur from multiple years while you were earning on your loan portfolio.
Stan Sokolowski: The red boxes are obviously areas of concern with very high default rates ranging from 14 to 20% and very high loss rates, ranging from 70% losses to about 55% losses. Let me make a personal observation. If that were to happen, many other asset classes would like dust, remembering once again that these assets, these loans sit at the top of the capital structure and they're secured by the assets of a company.
Stan Sokolowski: If we look at the green boxes, it gives you a pictorial of kind of where we've been in the past with the average default rates going back 30 years and average recovery rates going back 30 years, so you can get a sense for what's priced in today. This is a very important chart to think about because you may be more bearish, or you may even be more bullish than what markets have previously delivered, and you can get a sense of what's priced in.
Natalia Lojevski: We'll wrap things up with a reminder for us all that uncertainty is the only certainty there is. None of us can predict the future, but we can prepare for it. Perspective is probably especially difficult to achieve in today's world of chaotic social media and polarizing news narratives. Negative headlines can create hesitation and procrastination for investors. However, your clients do have to maintain some exposure to the markets. In the loan market, we hope that we have been able to provide some perspective that investors today are being adequately compensated for the risks that they are taking on.
Leland Abrams: My name's Leland Abrams. I'm the Chief Investment Officer, Wynkoop Financial. We're an FCC-registered investor and advisor based out of Denver, Colorado, and Southampton, New York. We manage several private hedge funds. We manage several real estate funds and we self-advise for Catalyst for a fund that invests in legacy RMBS. I also am on the Board of Directors for a public REIT called Front Yard Residential Corporation and I serve on the Audit Committee for that public company.
Leland Abrams: Today, we're going to talk about non-agency RMBS. We're going to talk about the market itself, the actual structure of the securities themselves, some of the dynamics in the housing market that are related to these securities, some recent developments that occurred in March 2020, and again, going forward, some outlook on this asset class. First, we talk about non-agency RMBS as an opportunity, but I want to backpedal a little bit and break out, what is non-agency RMBS versus agency? Mortgages in total actually happen to be the largest taxable bond market, yet most investors tend not to think about mortgages as part of their fixed-income portfolio. A lot of people tend to think about sovereign debt, corporate debt, and municipal and forget about mortgages, although mortgages are the biggest asset class in fixed income.
Leland Abrams: Agency mortgages are those that are guaranteed either implicitly or explicitly by the government through the GSE and the government-sponsored entities, Fannie Mae, Freddie Mac, and Ginnie Mae. Non-agency mortgages are those that are not guaranteed by the government and are originated by either banks or other mortgage origination companies. Some of those non-agency mortgages are held on bank balance sheets and some are packaged into deals and structured into securities and sold in the primary and then re-traded in the secondary markets.
Leland Abrams: Legacy RMBS or the term "legacy" refers to non-agency mortgages that were originated typically before the Financial Crisis saying that 2007 was basically the end of the origination debt. Legacy could be anywhere from mortgages originated in the '90s all the way up through 2007. The reason why this is important is the seasoning aspect. I think we all know how important seasoning is when we cook. We need salt and pepper on your burger. You also need seasoning for loans to make them safe.
Leland Abrams: As time goes by, every month borrowers pay a mixture of principle and interest. As they pay every month, the amount of outstanding debt goes down and they amount of home equity goes up, so every month, safer and safer. That's what we refer to as amortization. These are not bullet bonds like corporate bonds. Every month, they're getting some piece of their principle back and you have less and less debt outstanding. We call that de-levering amortization and effectively seasoning makes loans much, much safer.
Leland Abrams: Touching back again on the size of the structured credit market, non-agency RMBS as you can see is the largest portion of structured credit card. This is just a sampling of structured credit. There are many other things that are included in structured credit, basically anything that has a cash flow stream. It can be securitized and that's all considered to be structured credit. The largest segment of structured credit is non-agency RMBS, now at about 1.1 trillion of outstanding. That includes legacy and some of the more newly originated non-agency RMBS we call RMBS 2.0. Of the 1.1 trillion outstanding non-agency RMBS, about 300 billion of that is what we refer to as legacy.
Leland Abrams: As we touched on before, why would somebody invest in legacy non-agency RMBS? Seasoning, as we talked about, is very important because if we look back on loans that were originated 10. 12, 15, 18, 20 years ago, they are in the latter half of their payment cycle. They have tons of home equity, tons of pay history. Whatever was bad and fraudulent loans that were created in the bubble before the crisis, that's all been flushed out and now you're left with performing regular homeowners who have paid down their mortgages and are incentivized to stay in their homes due to the overwhelming amount of home equity that they have.
Leland Abrams: Mortgage delinquencies in the past 10 years have declined more than 50%. RMBS deals like we just touched on, positive selection bias, meaning that all of that fraudulent stuff that was in the news a decade ago, that's all been flushed out, it's all gone. We like to refer to it as an orphaned sector. There are hundreds of thousands of unique bonds. Only a handful of experts who really understand how to look at them. Very expensive software to analyze the cash flows and most of them were downgraded to junk through the crisis and as a result, we don't have a natural buyer base like you do for other fixed-income products. That also lends to it being cheap.
Leland Abrams: There are, obviously, new deals that have been created and those deals typically have much tighter underwriting standards for the loans and better structural enhancements for the bonds to make them safe and insulated from potential losses. Relative value, non-agency RMBS versus other fixed-income products. The unique structure that these bonds have allow them to withstand lots of defaults and still not take loss. That is something that makes them, especially the senior or the more senior part of the capital structure, very safe and because legacy loans were originated when the prevailing mortgage rates were in the fives and up to 6%, these loans and bonds that are backed by them have big coupons, not because they're risky, just because they're old.
Leland Abrams: Now, they're much safer than they were and they're safer than newer issued mortgages because they've de-levered. You have higher yield, higher coupon, and less risk. Like we said, hundreds of thousands of unique bonds with only handfuls of market participants who know how to examine and invest in them.
Leland Abrams: Now, obviously, there's relation to housing. That relation is more pronounced in the junior bonds at the bottom of the capital structure, which we call structurally levered. Those have the exposure to housing delinquencies, defaults, et cetera. The bulk of the transaction is the senior bonds that are supported by junior bonds. They don't really have a lot of relation to housing. However, over the past decade we've seen improving housing price appreciation, supply-demand technical which show a shortage of homes versus those who want to own.
Leland Abrams: A lot of renters are transitioning back to home ownership as rental rates have gone up dramatically. Prepayment incentives now are high. Now, even though these loans have big coupons, because they're seasoned, sometimes they don't necessarily refinance because either they have servicers that don't harass them on the phone to refinance or the cost to refinance may outweigh the benefits because they've de-levered the loan so much. It really depends. However, some bank service legacy stock is paying pretty fast given where prevailing mortgage rates are today, sub-3%, and because almost everything in the legacy market trades at discount dollar price, any refinancing is not a risk, it's a positive.
Leland Abrams: You get back par dollars every time there's refinancing and you get that money every single month. Default rates have been declining. Loss severities have been declining, which makes sense because you have housing price appreciation as well as less outstanding debt on the homes as people pay them every single month. Again, improving fundamentals, we touched on this, supply-demand, housing price appreciation leads to adjust much lower LTVs. Better recoveries than any loans that are liquidated. Recoveries go to pay senior bonds, losses would go against junior bonds, but effectively, it's getting better and better every month as it's designed to with seasoning.
Leland Abrams: Again, we've seen a trend back towards home ownership. Home ownership peaked around 70% in 2004 and hit a low in 2017 of about I want to say the low 60s, and it's creeping back up. More and more people are trying to buy homes and there are less and less homes available. Also, the amount of underwater properties has declined significantly since the great recession, meaning that most of these homes have equity in them.
Leland Abrams: Now, what happened in 2020 and what made this even more interesting and more compelling of a place to invest, there was a huge liquidity event in March of 2020 on the back of COVID and what it did to expectations to the economy, borrowers, et cetera. There were mass redemptions across a lot of large funds, mutual funds, hedge funds, REITs. The hedge funds and the REITs used financial leverage. They got into a vicious cycle of margin calls forcing more selling, propagating lower prices which forced more selling, et cetera, et cetera. That violent cycle took prices down tremendously, not because these bonds necessarily had more risk, but just mostly for liquidity.
Leland Abrams: Now, there are some parts of the capital structure and some deals out there where, obviously, there is some more risk on the table, but by and large, for legacy RMBS, there is [inaudible 00:39:14] increase in risk and there was a huge increase in risk premium. Now, again, why is it so attractive? Significant home price appreciation. 13 to 20 or more years of payment history amortization. Low rates now translate to excess spread in the transactions which actually protect the deal from losses while the LIBOR is very low.
Leland Abrams: Again, these bonds should not trade to new issue. In fact, they should trade tighter because of the seasoning aspect, but because as we touched on before, sort of it being an orphaned sector, not investment grade anymore, it actually trades cheap to newer issue mortgage deals which have tremendously more risk because they are new and they have much more leverage in the homes, et cetera, et cetera.
Leland Abrams: Here, how does an MBS work? You effectively have hundreds or thousands of mortgage loans, and if anyone listening on the call has a mortgage them self, you make that check payment every month or online, who does that money go to? That money goes to the servicer. That's your remittance. The servicer then takes the money and gives it to the trustee. All of these deals that issue certificates... Certificates is just the technical word for bonds, so the deals that issue the bonds are all bankruptcy remote trusts. Because of the great bankruptcy and trust laws in the United States, these deals work beautifully.
Leland Abrams: You have a trustee who makes sure that the money he gets from the servicer is applied according to the pooling and servicing agreement, which is just another term for a fancy legal document that tells you how the deal works. The trustee will then take the money and pay it to the bondholders in order of priority. Very typical and simply put, the money usually flows top of the capital structure down, and any losses would go bottom-up.
Leland Abrams: Here's what a legacy deal looks like over time. The point of this demonstration is to show you how what were the senior bonds in 2004 are now all current sized as 0000. That means they've been paid off at par. They've amortized away. Now, more junior bonds are now senior bonds, so what was a junior bond is actually high in the capital structure and is seasoned. These are very clean deals. This is a deal that none of these bonds likely should ever take a loss going forward because of the amount of credit support they currently have versus delinquent loans. This is what seasoning does. It pays off bonds. Notice all of these bonds up there are paid off at par despite having endured the Financial Crisis, et cetera.
Leland Abrams: A typical capital structure, it's a little bit out of scale. It started with a 2017 deal, but the idea's generally the same. You have your loans, and as you noticed, the blue and pink arrows, those are arrows pointing down and the collateral loss going up. Again, the money comes in, it pays down the waterfall, seniors, then the mezzanines, and then the juniors. Same with the interest waterfall, and any losses that occur from liquidation go bottom-up/
Leland Abrams: Now, what has happened post-March 2020, the obvious question would be, "Well, aren't delinquencies going up?" There are some different ways to look at this. Delinquencies in general across the whole universe of mortgages have obviously gone up a little bit. Some of the delinquencies are there because people are taking advantage of forbearance programs. Some people are still current but may go delinquent to take advantage of forbearance, so it's a little bit unclear, but in general, the universe is about six to seven percent uptick in delinquencies and those utilizing forbearance across all mortgages.
Leland Abrams: Legacy RMBS has only seen about a three- or four-percent increase because, again, it's so seasoned. It has so much equity in the homes, et cetera. Some of the newer issued, not just the RMBS, called non-QM, that is today's version of subprime, these are higher LTV loans, lower FICO borrowers. Again, those have seen spikes in the 14 to 20% range for a delinquency, so very important to not loop all mortgages together, but parse through different cohorts within non-agency mortgage to see where the effect may be. Again, legacy basically is the best place to be.
Leland Abrams: Okay, so now looking at this capital structure where payments go top-down, losses go bottom-up, let's look at the math here. This one says 33.3% credit support. Now, what is credit support? Credit support is bonds junior to you which are there to absorb loss first. If you bought Class A, you are able to withstand about 67% of all of the loans defaulting at a 50% recovery and you still wouldn't take a dollar of loss on that senior bond.
Leland Abrams: Now, again, look over here. It says 60-plus days delinquent, 3%, so it currently has 3% delinquent loans. You could default 67% of the loans with a 50% recovery and you still don't take a loss. That's actually the simple way to look at it. It's actually more complex. You could withstand more than 66% and still get paid at par because deals are structured with what we call excess spread. Many deals, sorry, many deals are. Excess spread is the difference between what the borrowers pay in and the aggregate coupons of the bonds. You notice here the loans say, "Coupon, 4.92." That's the weighted average coupon on the underlying loans. Almost 5%.
Leland Abrams: The bond coupons are at 3.1, 3.5, 3.5, 3.75, 2.75. There is excess money there, so what happens is if somebody defaults and the servicer goes through the process and liquidates the home, if there is greater excess spread than there is loss arising from the liquidation, then nobody takes a loss, not even the Class B 2. The structural enhancements to these deals at the senior level specifically, it's almost impossible for a bond like that to take a loss. Even the junior bonds can withstand more losses than they optically look like they can because of excess spread. Excess spread on deals has really gotten greater, especially if you have a deal that has floating rate coupons, livewire-plus. Those coupons have gone down, but they underlying loans are still paying in at a high rate, but excess spread has gone through the roof.
Leland Abrams: Excess spread is your first defense against loss. Furthermore, if you have a bond there that took a loss at some point in its life, excess spread can actually go to rebuild the outstanding face of a bond, built it back up and give you back your bonds. It's very, very powerful the way these deals are structured, and this is typical for many different types of securitization, but very typical in a lot of non-agency deals. Again, you have hard credit enhancement, you have excess spread. All comes together to defend your bonds from losses.
Leland Abrams: If you're concerned about upticks in delinquencies and defaults, at the senior level here, again, we touched on numbers that are almost crazy that you would need to experience in order to take a loss. These are very, very unique bonds, unique asset class. Something that certainly should be looked at and considered as part of a fixed-income portfolio, and that concludes this presentation.
Natalia Lojevski: Important risk considerations. Investing in the fund carries certain risks. The value of the fund may decrease in response to the activities and financial prospects of an individual security in the fund’s portfolio. The value of the fund may decrease in response to the activities and financial prospects of an individual security in the fund’s portfolio. The fund is a new mutual fund and has a limited history of operations for investors to evaluate. Investors in the fund bear the risk that the fund may not be successful in implementing its investment strategies. The fund is non-diversified and may invest a greater percentage of its assets in a particular issue and may own fewer securities in other mutual funds.
Natalia Lojevski: The fund is subject to concentration risk. Interest rate risk is the risk that bond prices overall, including the prices of securities held by the fund, will decline over short or even long periods of time due to rising interest rates. Bonds with longer maturities tend to be more sensitive to interest rates than bonds with shorter maturities. Lower quality bonds known as high-yield or junk bonds present greater risk than bonds of higher quality, including an increased risk of default. Credit risk is the risk that the issuer of a security will not be able to make principle and interest payments when due.
Natalia Lojevski: These factors may affect the value of your investment. Investors should carefully consider the investment objectives, risks, charges, and expenses of the Catalyst Fund. This and other important information about the Fund are contained in the prospectus which can be obtained by calling 1-866-447-4228, or at www.catalystmf.com. The prospectus should be read carefully before investing. The Catalyst Funds are distributed by Northern Light Distributors, LLC., member FINRA/SIPC. Catalyst Capital Advisors, LLC., is not affiliated with Northern Light Distributors, LLC. This presentation has been approved by Northern Light Distributors.